The
Short Call Butterfly is another volatility strategy and is the opposite of a
Long Call Butterfly, which is a rangebound strategy. The reason that short butterflies
are not particularly popular is because even though they produce a net credit,
they offer very small returns compared to straddles and strangles with only
slightly less

risk.

The
Short Call Butterfly involves a low strike short call, two ATM long calls, and
an out-of-the-money short call. The resulting position is profitable in the
event of a big move by the stock. The problem is that the reward is seriously
capped and is typically dwarfed by the potential risk if the stock fails to
move.

Market
Opinion

Direction
neutral.

P/L

When
To Use

Use
this strategy when you anticipate a stock moving with increasing volatility, in
either direction, for a capital gain.

Example

XXXX
is trading at $50 on May 14, 2011.

Sell
August 2011 45 strike call for $7.98.

Buy
two August 2011 50 strike calls at $5.28.

Sell
August 2011 55 strike call for $3.35.

Net
Credit: premiums sold minus premiums bought = $0.77

Benefit

The
benefit is that, with no capital outlay, you can profit from a rangebound stock
with capped risk and the possibility of big profit if the stock moves
aggressively.

Risk
vs. Reward

The
risk is the difference between adjacent strikes minus the net credit. The
reward is the net credit you received.

Net
Upside

Net
credit received.

Net
Downside

Difference
between adjacent strikes minus net credit.

Break
Even Point

Break
even up: higher strike minus net credit.

Break
even down: lower strike plus net credit.

Effect
Of Volatility

Volatility
is positive for this position, unless the stock moves outside the outer
strikes.

Effect
Of Time Decay

Negative.
It harms the position since you are looking for a lot of movement in the stock
price.

Alternatives
Before Expiration

To
stem a loss, you can close out your position before expiration.

Alternatives
After Expiration

Close
out the spread by selling the options you bought and buying back the options
you sold.

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